I spent several hours on Saturday going through the McKinsey Institute website. It is free and I would recommend that you have a look. If you do not fancy reading the full report, there is a 20 minute podcast that you can listen to, which gives a basic overview. There are several takeaways from the website,
The report highlights that deleveraging occurs in the various sectors of the economy. In the U.S. the present position is:
1. The household sector debt peaked at 138% of disposable income in 2007. Since the crisis in 2008, this sector has reduced debt to a present 112% of disposable income. In the just over 3 years since the deleveraging began, the annual rate of decrease is approximately 7.8% per year. The question is when will households feel comfortable with their long term debt burden. The Swedish and Finnish examples of household deleveraging in the 1990s both resulted in reductions of approximately 30% of the debt to disposable income level. This would suggest a level of 96.6% as the level that households are happy with. This would imply another 2 years of household deleveraging and would also fit the Institute's average timescale for deleveraging of 6-7 years. The figure 96.6% is also close to the long term trend of household debt to disposable income which would at that time be around 100% (click on graph below to enlarge).
A reasonable guess therefore, from the information in the website, seems to be that household deleveraging should end sometime close to the start of 2014. The report highlights that servicing costs for household debt are at historic lows, near 11.5% of disposable income, which is helping consumers reduce the burden of their debt. But it does not suggest that this will reduce the timescale of the debt reduction process.
My thoughts: The only thing that worries me about the graph above is that the trend is up. But can this continue indefinitely? This implies that in the future, the level will once again be back above 138 and that households will be happy with that level of debt as it is the trend line. This seems to defy reason. I note that the level between 1960 to 1980 is almost unchanged at 60%. Is that a more reasonable level that we should be looking at- as a percentage that consumers feel happy with and implying 6.7 more years of household deleveraging? This, however, is not the message from the McKinsey Institute.
2. The report goes into the sectors of households and their debt profiles. The largest build of debt was in the top 20% of U.S. earners and accounts for almost 50% of the increase in debt in the 2000s. This sector is closely followed by the large middle class sector. The lowest 30% account for very little of the increase of debt and this section can reasonably be ignored in the great deleveraging. The report also suggests that 70% of the reduction in debt is due to default, which McKinsey says is due to the lowest earners being distressed.
My thoughts - The reduction in size of the financial sector and the reduced bonuses paid to bankers will have a great effect on the deleveraging process. If we further reduce CEO's salaries and the highest paid section of our society (which seems likely), the effect will be to increase the effect of deleveraging. The fact that 70% of deleveraging is through default suggests that the higher earners are not reducing their debts (as default is generally from the lower paid sections of society). But this will change if their income levels are affected.
3. There are also figures on the effect of the savings rate. A 1% decrease in the savings rate equates to a $100 billion increase in retail sales.
My thoughts - The fourth quarter GDP report had the savings rate down to 3.7%. Despite this, consumption was up only .1%. If the savings rate were to go back to 5%, the loss of sales would be $170 billion. This is 1.1% of current GDP.
4. The report highlights that the only other sector of the U.S. economy that is highly leveraged is the commercial real estate market (CRE). The report suggest that this may lead to further deleveraging of the financial sector as losses are taken by the banks. However, this seems to them to be only a medium risk event. The financial and corporate sector debt levels are not excessive and are unlikely to change substantially from here. The report suggest that the present path of the Basel regulations may mean that the financial sector deleverages somewhat further, but that the major adjustments have already been taken. Non-financial corporate debt is not onerous and will likely not be reduced in the coming years. It would seem that the only other problem is that as loans to the CRE market are due for renewal, the banks will be unwilling to roll over the loans as the collateral is no longer good enough. This will result in some defaulted CRE loans. The report does not state a timescale for this to occur.
5. I get the impression that if the U.S. was alone in having to delever, the institute would consider it a reasonably simple case. The position is complicated however as there are so many countries trying to achieve the same outcome at the same time. This creates two problems:
- World growth will be below trend hampering any growth prospects for the U.S.
The U.S. will find it more difficult to depreciate the dollar and increase exports as several other major economies will be doing the same. McKinsey states export growth as one of the major ways that indebted economies can reduce their debt burden.
The report suggest that this will mean that the U.S. will have to walk a very difficult path on when its government can withdraw fiscal stimulus. Too soon and the U.S. may face a return to recession. Too late and the public debt burden becomes too large, leading to a loss of confidence in the currency.
My thoughts - The report draws on 16 episodes of deleveraging that have occurred due to austerity. All of them are stand alone examples, none have occurred with multiple economies doing it together. This makes the conclusions less valid (although still very helpful) and likely means that the present episode is longer and more troublesome than previous examples. I would suggest that this episode is more likely to last 10 years or more rather than the 6-7 years that are normal. This would make the end of deleveraging somewhere around 2018. This is also borne out by the fact that fiscal stimulus is only normally required for approximately 2 years before it can be slowly withdrawn. We are presently on 3 years and counting and I am sure if stimulus was withdrawn now, it would result in another recession. The institute, however, does not put any different timescale on the present episode, merely noting that the above factors will make this one longer and more difficult.
The next 2 years (and probably longer) are going to be just as volatile in markets as the last 9 months have been. It is highly likely that growth in the U.S. will continue to disappoint during this time, due to household deleveraging. The U.S. market is vulnerable to a downturn if it no longer responds to injections of liquidity from the Fed. Eric Parnell has just written on this subject and I have previously written on it here. This is the most important point for investors to consider: If you believe the liquidity argument, the long position is still the most attractive. However, if you think that the liquidity effect will diminish with the lack of fiscal stimulus, you should be in cash (or short) awaiting better entry levels.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Long RWM
Disclaimer: This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.